The Great Risk Dispersion that Wasn’t

June 5, 2008

The Daily Telegraph in London has an interesting article comparing bank strategies today with similar strategies used in 1929:

Perhaps the most intriguing parallel…is the crude attempt at self-preservation made by the investment trusts in 1929 and the banks now.

In the great crash, investment trusts with vast cross-holdings in each other tried to stem their collapse by buying up their own stock in what the economist JK Galbraith…described as an act of “fiscal self-immolation”. At the time, “support of the stock of one’s own company seemed a bold, imaginative and effective course,” Galbraith wrote, but ultimately the trusts were just “swindling themselves”….

To free their books of the estimated $1,000bn (£505bn) of sub-prime assets and $340bn of leveraged loans banks have been left carrying since the credit markets shut down last year, [many] are offering to sell these damaged assets cut-price and – crucially – are willing to lend investors the money to buy them. In other words, the banks are providing new debt for the old debt they no longer want.

Experts refer to such financial chicanery as adding “liquidity” to the financial system. All that’s really happening is a game of high finance hot potato: handing off bad debts between banks and big investors. None of this repairs the credit markets’ fundamental problem of solvency. It doesn’t change the fact that in the end, someone is going to get burned holding the defaulted loan of a bankrupt borrower. [For a great discussion of the difference between liquidity and solvency, see Paul Krugman].

The article notes that today’s banks think themselves “more sophisticated” than those that faced the Great Depression. “Sophisticated” moves like the ones above will not just solve liquidity problems, say the banks, they could mitigate solvency issues as well. I wouldn’t hold my breath.

I’m very skeptical of the “sophistication” of modern bankers. And let me explain why….

In a speech to the Council on Foreign Relations back in 2002, Alan Greenspan—supposedly the brightest financial bulb of them all at the time—toasted the virtues of international financiers, particularly their many “innovations” that enabled wider, more international “dispersion” of financial risk:

These increasingly complex financial instruments have especially contributed, particularly over the past couple of stressful years, to the development of a far more flexible, efficient, and resilient financial system than existed just a quarter-century ago.

Speaking specifically about credit-default swaps, CDOs, and other “pooled asset securitizations” like mortgage-backed securities he said they had “improved credit risk management.”

These innovations were all part of a new “paradigm” that “emphasized dispersion of risk to those willing and…able to bear it.

“If risk is properly dispersed,” he argued “shocks to the overall economic system will be better absorbed and less likely to create cascading failures that could threaten financial stability.”

Wow. That’s a lot of rope with which to hang the man’s reputation. Please, allow me.

In the end, such financial “innovations,” in creating the veneer of risk “dispersion” served only to encourage more risk-taking. You could take the junk-rated components of a bunch of different mortgage-backed securities, mix them all together to achieve “diversification” and, voilá!—you have a new, investment-grade issue called a CDO! And Wall Street has a new product to sell that will generate fees.  And by keeping real interest rates negative for so long, Greenspan encouraged lenders to create as much money as possible, and they obliged him.

[Greenspan is a smart guy. In the middle of his speech, he acknowledges concerns that overconfidence can lead to excessive risk-taking and that this put additional responsibility on regulators. And yet he ends the speech with an ode to unfettered competition that would have made his mentor Ayn Rand proud. Indeed this is how he faced the bubbly mortgage markets in the years to follow, famously ignoring the warnings of Fed Governor Ed Gramlich, who said as early as 2000 that the Fed should investigate crooked mortgage lending.]

The bottom line is that the new methods for credit-creation break the link between borrower and lender. Once upon a time, bankers knew the borrower, knew his ability to repay, and refused to lend him money if they thought he couldn’t. Is this “discriminatory” because it would prevent subprime borrowers from getting credit? Some would say so. I would just call it prudent. Better too little credit creation than too much…

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